CASE 2
Summary:
Blades (American company) exports shoes to Thailand.
⁃ This company signed an agreement to export shoes to Thailand for a period of 3 years,
with a fixed price of 4,594 baht/pair, totaling 180,000 pairs per year.
⁃ The American company also imported rubber and plastic components from Thailand to
make shoes at a price of 2,871 baht/pair, but there was no contractual agreement exists
A short time after Blades exported to and imported from Thailand:
Asia has an economic crisis -> foreign investors withdraw capital simultaneously -> the
baht’s value plummets => the Thai government has to intervene.
Result: unsuccessful.
Baht continued to decrease sharply in the next 3 months.
Blades CFO was concerned:
+ Company profits were strongly affected because the baht continued to decrease
+ Swap agreement of Thai government affects exchange rate
+ Is the decision to sign an export contract with a fixed price for Thailand right?
1.
Did the intervention effort by the Thai government constitute direct
or indirect intervention?
-The intervention effort by the Thai government constituted direct intervention,
since the government exchanged dollar reserves for baht in order to
strengthen the currency. This action would increase the demand for baht and
supply of dollars for sale, which puts upward pressure on the baht.
(In indirect intervention, a central bank attempts to influence the value of a
currency by influencing the factors that determine it. For example, if the Thai
government wanted to strengthen the Baht, it could have increased interest
rates by decreasing the Thai money supply)
2. Did the intervention by the Thai government constitute sterilized or nonsterilized
intervention? What is the difference between the types of intervention? Which type do
you think would be more effective in increasing the value of the baht? Why? (Hint:
Think about the effect of nonsterilized intervention on U.S. interest rates.)
Nonsterilized intervention
Sterilized intervention
The central bank purchases or
sells foreign currency without
taking any steps to mitigate the
impact on the domestic money
supply. This has a direct effect on
the monetary base, which affects
inflation and interest rates.
The central bank buys and sells foreign currency in
the foreign exchange market while also conducting
open market operations (such as purchasing and
selling Treasury securities) to reduce the impact on
the domestic money supply. This ensures that the
money supply remains constant, reducing the overall
economic impact.
-So the Thai government's intervention was nonsterilized since it involved direct baht
purchases in the foreign exchange market using dollar reserves and no offsetting
adjustments in the domestic money supply. A decline in the money supply, which raises
interest rates, is a strong indication of nonsterilized intervention that is "Thailand's money
supply probably decreased, which raised interest rates."
-A nonsterilized intervention is often more effective in enhancing the value of a currency
since it has a direct impact on money supply and interest rates:
+When the Thai government purchases baht on the foreign exchange market, it reduces the
supply of baht, which will increase its value.
+But because the Thai government didn't sterilize the intervention, Thailand's money supply
probably decreased which raised interest rates.
=>Increased demand for the baht should boost its value since higher interest rates attract in
foreign capital inflows from investors looking for higher returns.
3. If the Thai baht is virtually fixed with respect to the dollar, how could
this affect U.S. levels of inflation? Do you think these effects on the U. S.
economy will be more pronounced for companies such as Blades that
operate under trade arrangements involving commitments or for firms
that do not? How are companies such as Blades affected by a fixed
exchange rate?
ANSWER:
*
Effect on U.S inflation
If the Thai baht is fixed to the U.S. dollar, exchange rate fluctuations
between the two currencies are minimal or nonexistent. This stability can lead
to cheaper imports from Thailand for U.S. businesses and consumers, as
Thailand is a lower-cost producer for certain goods. As a result, production
costs for U.S. companies that rely on Thai imports could decrease. Lower
costs for imported goods could, in turn, put downward pressure on U.S.
inflation since companies would not need to raise prices due to currency
fluctuations.
*
Effects on Companies with Trade Agreements (Like Blades) vs. Those
Without:
For companies engaged in trade agreements, such as Blades, the
effects of a fixed exchange rate can be significant. Blades has committed to a
fixed price of 4,594 baht per pair of roller blades over three years. If the baht
remains weak or artificially fixed at a lower rate, the company might receive
less in real value when converting baht to U.S. dollars. Additionally, while
Blades' revenue per unit is fixed, its cost of imported rubber and plastic
components (2,871 baht per pair) could fluctuate if Thai suppliers raise prices
due to inflation or other economic factors. This could result in higher input
costs and reduced profit margins. In contrast, companies without long-term
trade commitments can remain more flexible, adjusting their pricing strategies
based on currency fluctuations and economic conditions.
*
How Blades is Affected by a Fixed Exchange Rate:
In the short term, a fixed exchange rate provides Blades with stability in
pricing and financial planning, allowing the company to predict costs and
revenues more accurately. However, in the long term, risks emerge if the Thai
government is unable to maintain the fixed exchange rate. If the baht
eventually devalues, Blades' revenues, which are fixed in baht, would be
worth less in dollar terms, leading to losses and lower profit margins.
Furthermore, even with a fixed exchange rate, inflation in Thailand could
increase the costs of raw materials, such as rubber and plastic, making
production more expensive while Blades’ selling price remains unchanged.
4.
What are some of the potential disadvantages for Thai levels of inflation
associated with the floating exchange rate system that is now used in
Thailand? Do you think Blades contribute to these disadvantages to a great
extent? How are companies such as Blades affected by a freely floating
exchange rate?
A freely floating exchange rate could exacerbate Thailand's inflation. If
domestic inflation is high, the baht may weaken due to reduced market
confidence. A weaker baht increases import costs, causing the prices of raw
materials and domestic products to rise, contributing to the inflationary spiral.
At the same time, higher import prices may cause Thai consumers to switch to
buying domestically produced goods.
Blades does not directly contribute to this issue, as both the company's
exports and imports are calculated in baht. However, the company still faces
the risk of converting profits from baht to USD. If the baht continues to
depreciate, when converted to USD, Blades' revenue will decrease, affecting
actual profits. Additionally, high inflation and the decrease in real income of
the Thai people could reduce demand for Blades' products.
To mitigate risks, Blades could consider using forward contracts to lock in the
baht/USD exchange rate and explore diversifying their raw material supply
outside of Thailand to avoid reliance on a single market.
5. What do you think will happen to the Thai baht’s value when the swap
arrangement is completed? How will this affect Blades?
Let’s see what will happen after the completion of the swap arrangement.
The Thai government's intervention by buying baht and selling USD aimed to
reduce the supply of baht and temporarily increase demand, which could help
ease inflation or even slightly appreciate the baht in the short term. However,
there are important factors to consider.
First, Thailand's USD reserves will gradually deplete if the swap scale is too
large, causing investors to lose confidence in the baht, leading to further
depreciation.
Second, Thailand's economy was already weakening at that time. If the
situation could not be temporarily stabilized, speculators would sell off their
investments, capital outflows would increase significantly, and the baht would
undoubtedly depreciate further.
Conclusion: The intervention might help stabilize or slightly strengthen the
baht in the short term, but in the long run, the baht is likely to continue
depreciating.
Regarding impact on Blades, with the higher revenue compared to costs of
components, this company generates a net inflow in THB. Besides, we have 2
problems to take into consideration.
*Fixed price on export orders: with 4594 THB per pair under the contract
with Thailand company. Obviously, if the THB continues to devalue, Blades
will gain much less profit as the exchange rate of THB to USD increases.
*saving the potential import price: Blades imports components from thailand
with 2871 baht/pair, under no official contract. To be clarified, the weaker the
THB is, the less amount of USD the US company has to pay, this can reduce
a lot for manufacturing. However, there was no commitment in this trade,
inflation in Thailand can cause more expensive raw materials, the US
company couldn't take advantage of this anymore.
profit margin would shrink, which possibly depressing the company's
shareholders.
Is it gud or bad for Blades to make this fixed decision???
*some advantages are given to support their contract:
+ By maintaining a fixed contract price, they can avoid intense competition
with other brands in the industry. This strategy helps retain loyal customers
and strengthens the company’s reputation.
+ revenue stream will be ensured, reducing uncertainties in demand.
*Restrictions still exist, if inflation in THB fluctuates making the fixed contract
less favourable over time as the Blades cannot adjust selling prices.
besides, exchange rate leaves a pivotal impact on US company’s revenue,
and the contract did not include any article to flexibly adjust prices when
exchange rate fluctuated.